Financial Education

Like convertible bonds, debt with warrants attached are issued with a feature that allows the bondholder to purchase a given number of shares at a certain price. However, while the conversion feature is built into the price of a convertible bond, it is a separate component of a bond with a warrant attached.

With a convertible bond, at or before the maturity date the bondholder either receives the face value of the bond or the number of shares into which the bond is convertible. For a bond issued with warrants, the bondholder gets a straight bond, and also receives warrants giving the right to purchase shares at a given price. These warrants are usually detachable from the bond, meaning they can be sold separately if the bondholder no longer wants the option.

A $1,000 bond with warrants attached might sell for $1,050. If the interest rate on the bonds is 6%, the company’s effective cash interest payment relative to the funds raised is $60/$1050, or 5.7%. Of course, the company also faces equity dilution when the warrants are issued.

Global Payments is a leading payment processing and consumer money transfer company. The risk factors section of their 10-K notes the following:

We are exposed to foreign currency risks because of our significant card processing operations in Canada, the Czech Republic, and those in the Asia-Pacific region, as well as our significant electronic money transfer operations in the U.S. and Europe.

We have significant operations in Canada which are denominated in Canadian dollars. In addition, we have significant operations in the Asia-Pacific region, the Czech Republic and Spain. We are subject to the risk that currency exchange rates between these regions and the United States will fluctuate, potentially resulting in a loss of some of our revenue and earnings when such amounts are exchanged into U.S. dollars.

We also have significant money transfer operations in the U.S. and Europe which subject us to foreign currency exchange risks as our customers deposit funds in the local currencies of the originating countries where our branches are located, and we typically deliver funds denominated in the home country currencies to each of our settlement locations.

Global Payments’ revenue and net income for the three years ending May 31, 2007 are summarized below.

However, turning to the statement of shareholder equity we see that there were significant other components of “total comprehensive income.”

The most significant adjustment is the foreign currency translation adjustment, which results from the net assets of foreign subsidiaries being translated into dollars at current exchange rates. Since the amount is positive in all periods, if the subsidiaries have positive net assets the amount reflects strengthening foreign currencies (a weaker dollar.) The adjustment does not flow through the income statement unless the gains or losses are realized. However, it does reflect the underlying economic position and investors may also want to adjust the statements for better comparison to firms that translate foreign operations using the temporal method.

All one needs to do is replace net income with total comprehensive income.

Since the currency adjustments were positive in all three years, profit margin based on comprehensive income were higher in all three years. Had foreign currencies weakened against the dollar, margins would have been reduced. In addition, the profit margins were much more volatile when based on comprehensive income – rising 440 basis points in 2006 rather than 200, then falling by 290 basis points in 2007 rather than 30.

Furthermore, net income growth patterns are markedly different from the growth in comprehensive income. Net income grew at double digit rates in both 2006 and 2007. Comprehensive income, however, rose faster in 2006 and actually declined in 2007.

Value investors look for stocks that are cheap, typically relative to either their assets (price/book) or their earnings (price/earnings.)  Value investors often believe that, in aggregate, other investors are willing to pay too much for popular glamour stocks and that the less popular stocks are underpriced due to neglect.  Efficient market believers usually ascribe the cheaper price to risk factors that investors are accurately pricing into the stocks.

Anyone can see that a stock is cheap. Successful value investors need to understand why a stock is cheap. Is it simply due to neglect, or is there a good reason for the low value? Are other investors missing something, or is the value investor failing to interpret the market’s reason for the low valuation? Is there a catalyst to make the stock rise to its proper value, and if not how long must one wait for the market to recognize the mispricing?

The main subsets of value investors are those who look for a low P/E ratio (usually in hopes of mean reversion), those who seek high dividend yields (and accepting most of the return potential as dividends), and contrarians. Contrarians seek companies that often have little or no earnings and are trading near or below book value. Often this is due to cyclical weakness that can be reversed during the cyclical recovery. Other times the contrarian investor may expect management to turn the performance around.

Source: Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)

Convertible bonds can be exchanged for shares at the option of the bondholder, who clearly will do so only when it is more beneficial than holding the bonds for redemption at face value. Since the bonds can be converted into equity, they retain characteristics of both types of securities.

An investor considering buying shares in a company should evaluate whether converting the bonds into equity would significantly increase the number of shares outstanding, which would impact earnings per share. Investors in both debt and equity securities would want to consider the possible impact on the company’s financial condition, such as is illustrated by the debt/equity ratio.

If the conversion price of the bond is significantly higher than the market price of equity securities, conversion is unlikely. The bonds would be more appropriately treated as debt.

If the conversion price of the bond is significantly lower than the market price of the stock, conversion is likely and it may be appropriate to reclassify the debt as equity using either the book or market value of the debt.

If the conversion price of the bond is near the market price of the stock, the bond retains many qualities of both debt and equity securities. It may be useful to treat it as both debt and equity, and to compare the impacts of various scenarios.

Capital leases are treated by the lessee as though the asset was purchased and financed by the seller. For the lessor, however, the accounting treatment depends on whether the lease is classified as direct financing or as a sales-type lease.

If the present value of future lease payments is greater than the asset’s cost the lease is treated as a sale of the asset. The asset value is recorded as revenue at lease inception, and the asset cost is recorded as cost of goods sold. The lessor will also report interest income on the lease payments as received.

As with a direct-financing type lease, the value of the asset is replaced by a lease receivable of equal value on the balance sheet.

Capital leases are treated by the lessee as though the asset was purchased and financed by the seller. For the lessor, however, the accounting treatment depends on whether the lease is classified as direct financing or as a sales-type lease.

If the present value of future lease payments is equal to the asset’s cost (i.e. there is no profit) the lease is treated as direct financing, and the income statement treatment is financing in nature (interest revenue.) The value of the asset will not be inculded as a “sale,” nor would there be a related cost of goods sold.

On the balance sheet, the value of the asset is eliminated, and replaced by a lease receivable of equal value.

One explanation for stock price momentum is that investors react slowly to changing circumstances. In the May/June 2007 Financial Analysts Journal Ilya Figelman studies the interaction between earnings measures and past stock returns.

Large-cap companies with high ROE but poor recent stock returns significantly underperform the market and companies with poor stock returns but low ROE. Figelman suggests that the poor recent returns for such companies results from some investors recognizing that profitability has peaked for such firms, while the continued underperformance suggests that it has not been efficiently priced by all investors.

Companies with poor past returns and poor earnings quality (high accruals) significantly underperform both the market and those companies with poor past stock returns and high earnings quality. Therefore, investors also appear to react slowly to earnings manipulation.

This section presents ratio analysis of Brazilian steelmaker Gerdau SA and U.S. steel producer Nucor. The reported numbers of these firms cannot be compared directly due to differences in size and currencies. Therefore, it is important to create ratios for each. Investors should also consider differences in accounting standards internationally when interpreting the ratios. Further, a time series analysis of each firm ratios calculated for three to five years in order to identify trends. Since many ratios require average balance sheet data, six years of data are required to compute five years of ratios. Since financial statements only contain data for two years of the balance sheet, it is necessary to either collect prior annual reports or use a data service such as Bloomberg, Baseline or Compustat. The tables below provide summary financial data from Zacks Research Wizard and the company financial statements for Gerdau and Nucor, respectively. Commercial databases almost always aggregate financial statement data into common categories. For example two or three income statement line items may be aggregated into one expense category. This can improve comparability between firms but can also result in a loss of information. The analyst must consider this when interpreting ratios.

In the following sections we examine selected ratios from the activity, liquidity, solvency and profitability categories to assess the relative performance and financial position of Gerdau and Nucor.

Activity Ratios

Recall that the activity ratios provide indicators of efficient operations. The inventory turnover ratios for Motorola (MOT) and Nokia (NOK) for 2001, using the average inventory, are as the follows:

Computed directly from this ratio is the measure of days in inventory:

It appears that Nucor is much more efficient at managing inventory. In 2006, Nucor’s inventory on hand averaged only 33.7 days versus 84.1 for Gerdau. Nucor also seems to be improving its days inventory (though lumpily) over the five-year period, while Gerdau’s has remained fairly steady. In 2006 Gerdau wrote off some inventory, causing the turnover ratios to appear better than they otherwise would have. Nucor accounts for inventory using the last-in, first-out (LIFO) method. In a period of generally rising prices this tends to inflate COGS (higher-priced recent purchases are recorded as the cost) and reduce inventory (which consists of “older,” lower-priced product.) Both aspects of LIFO accounting tend to increase turnover and reduce days inventory. Therefore, further analysis would be needed to determine whether Nucor’s ratios reflect greater efficiency or are simply accounting artifacts.

Accounts receivable turnover and days receivable indicate how these firms manage the collection of credit sales. A weakness in these two ratios as computed using financial statement data is that companies typically do not disclose credit sales separately from cash sales. Since neither Gerdau nor Nucor indicate credit sales separately, the turnover calculation is presented using total sales revenues, equivalent to assuming that all sales are made on credit .

Accounts receivable turnover:

Days sales outstanding:

Once again, Nucor appears to be doing a better job than Gerdau. Nucor requires on average 25.6 days to collect receivables while Gerdau is taking 31.8 days. Both companies have been improving their collections over the last five years.

To examine the overall efficiency of the two firms we can consider the total asset turnover ratio:

Gerdau is generating $1.00 of revenues for every $1.00 invested in assets. Gerdau’s ratio was rather stable over the last five years. Nucor’s ratio, on the other hand, is much higher and improved dramatically during the five year period. Specifically, there was a large increase in efficiency reported in 2004. According to the MD&A section of the 2004 annual report, “Net sales for 2004 increased 82% to $11.38 billion, compared with $6.27 billion in 2003. The average sales price per ton increased 66% from $359 in 2003 to $595 in 2004, while total shipments to outside customers increased 9%.” Given that steel is a commodity, it is curious that Gerdau did not see a similar efficiency boost. It is possible that steel tariffs imposed by the U.S. in March 2002 were having an ongoing effect. A November 10, 2003 article in USA Today notes that Nucor was a strong supporter of the tariff, suggesting it did indeed benefit:

Steel producers and unions are demanding that Bush resist the WTO. “The steel industry is a test case for problems facing all sectors of U.S. manufacturing,” said Daniel DiMicco, CEO of Charlotte-based Nucor (NUE), the USA’s largest steel producer. “All of America is watching.”

Liquidity ratios

Examination of the short-term liquidity of each company is presented in the current ratios and the quick ratios for each company.

Current ratio:

Quick Ratio:

Both companies have generally been increasing their liquidity over the last several years, though Gerdau’s deteriorated somewhat in 2006. Nucor has consistently been more financially liquid than its peer.

Solvency Ratios

To examine the relative solvency of Gerdau and Nucor we can look at the proportion of liabilities on the balance sheet.

Debt-to-assets ratio (using total liabilities):

Debt to capital:

Both companies have been consistently reducing leverage. Care must be taken in interpreting solvency ratios. On one hand a high level of leverage indicates a low level of solvency; however, as pointed out earlier, leverage can be beneficial if the company borrows at a rate lower than it can earn on the proceeds in its business. Given that interest rates were low and declining during the 2002-2006 period, the reduction in leverage is somewhat curious.

Profitability Ratios

Here we examine the ability of Gerdau and Nucor to generate profits based upon the level of assets and equity invested in the companies.

Return on assets:

Return on equity:

Return on assets measures the return generated based upon total assets invested in the firm. Both companies began with very low returns on capital and ended the period with very high returns. Such wide fluctuations are common in cyclical industries such as steel.

To further examine the trend in ROE we can look at a decomposition of ROE:

From 2002 to 2006, the increase in Gerdau’s ROE was primarily due to an improvement in operating margin and lower tax rates. This was offset by a lower leverage.

In the case of Nucor, operating margins were by far the most significant ROE driver.

Update: This post was featured in the Carnival of Investing.

Under U.S. GAAP, assets must be carried at historical cost, less any charges for depreciation, amortization and impairment. Under no circumstances can assets be revalued to a higher value.

International Standards permit upward revaluation of assets if the fair value of the assets increases. Typically the new value is based on an appraisal.

Upward revaluations can affect comparisons between companies that have revalued and those that have not. Further, upward revaluation results in more favorable leverage and solvency ratios. As a result, investors may wish to adjust the financial statements to remove the impact of upward revaluation.

As of December 31, 2006 US Cellular Corporation (USM) reported long-term debt of $1.0 billion and total assets of $5.7 billion, resulting in a debt/assets ratio of 17.5%. It also recorded interest expense of $94 million and Earnings Before Interest and Taxes (EBIT) of $407 million, resulting in interest coverage of 4.3x.

In US Cellular’s 10K, the following disclosures are made regarding asset retirement obligations:

U.S. Cellular is subject to asset retirement obligations associated primarily with its cell sites, retail sites and office locations. Asset retirement obligations generally include obligations to remediate leased land on which U.S. Cellular’s cell sites and switching offices are located. Also, U.S. Cellular is generally required to return leased retail store premises and office space to their pre-existing conditions. The asset retirement obligation is included in Deferred Liabilities and Credits in the Consolidated Balance Sheets.

During the third quarter of 2006, U.S. Cellular reviewed the assumptions related to its asset retirement obligations and, as a result of the review, revised certain of those assumptions. Estimated retirement obligations for cell sites were revised to reflect higher estimated costs for removal of radio and power equipment, and estimated retirement obligations for retail stores were revised to reflect a shift to larger stores and slightly higher estimated costs for removal of fixtures. These changes are reflected in “Revision in estimated cash flows” below. The table below also summarizes other changes in asset retirement obligations during the year ended December 31, 2006 and 2005.

We can use this disclosure to adjust the financial statements and treat the ARO as equivalent to financial obligations. Since there are no offsetting trust funds, the process is as follows:

1. Reduce the $128 million ARO as of 12/31/06 by the company’s 38.5% tax rate, to $79 million.
2. Add the $79 million to reported long-term debt of $1 billion.
3. Add the $7 million accretion expense to both EBIT and Interest expense.

As a result of these adjustments we can recalculate the ratios as follows:

Debt/Assets = (1.0 + 0.08)/5.7 = 18.9%
Interest coverage = (407 + 7)/(94 + 7) = 4.1x

The resulting ratios are noticeably different from the unadjusted ratios, but in this instance probably would not significantly impact the evaluator’s opinion.